External Investors' Protection and Firm Boundaries

Abstract

Recent empirical studies have shown that external investors' protection from expropriation is the single most important factor to explain the large cross countries differences in the access of firms to external finance. This paper analyzed the consequences of poor external investors' protection on the boundaries of the firm. By modeling these boundaries in the property right tradition it shows that credit constraints are endogenous to the boundaries of the firm and thus the organization of production and financial arrangements are complementary tools to overcome difficult access to external finance. Organizational forms and finance methods appear to be complementary: vertical integrated structure will tend to be financed with debt, while outsourced relationships will be financed with equity. Ceteris paribus, it is shown that an improvement in credit market imperfections leads to more outsourcing and equity finance, but does not necessarily lead to higher efficiency. The model can be extended to shed some light on phenomena as diverse as the effects of quasi rents on organizational and financial decisions, the financing of spin off companies and the adoption of technologies in developing countries. All the results are shown to be broadly consistent with empirical evidence.

Keywords: Firm Boundaries, Credit Constraints, Investors Protection

JEL Classification: D23, G32, K12, L22, O10